Tuesday, April 07, 2015

Bond bubbles

Apparently, I convinced Brad DeLong that the idea of a "bond bubble", though a slight misnomer, is not insane. Brad's explanation of the idea is a little convoluted, so let me see if I can boil it down to essentials.

Why can't a government borrow and spend infinite amounts of money? Well, interest payments might get too high, forcing the government to default. But what if interest rates keep getting lower and lower? As nominal interest rates go to 0, interest payments go to 0, so the govt. will always be able to make interest payments no matter how big the debt gets.

So all the govt. has to do in order to be able to borrow and spend infinite amounts of money is to get the central bank to keep interest rates at 0 forever, which the central bank can do by - basically - printing money and buying bonds from people and banks.

But what if people and companies stop buying the government bonds in the first place? Well, the central bank can just print money and buy the bonds directly from the government. (We call this "the full MMT." It is almost certainly the route Japan will have to take.)

So is this a free lunch? What's the danger? The danger is that all that money-printing will eventually result in a big inflation. A big inflation will also raise nominal interest rates, overwhelming the central bank's ability to keep them down. That will cause a government default.

So is this a danger for advanced countries right now? Well, markets have very low expectations for future inflation, and for future interest rates, for most rich countries. If you believe markets are efficient, this means that it's likely that governments can keep borrowing money, and central banks can keep printing money, without causing inflation - at least for now.

BUT, if markets are not efficient, then people could be underestimating the risk of a rise in inflation and interest rates. That is what people are afraid of when they talk about a "bond bubble." No, it's not a speculative bubble, but whatever. This is what I pointed out to Brad DeLong.

Note, btw, that a bond bubble isn't the only reason to take low inflation expectations with a grain of salt. Those low expectations could be based on people's predictions that governments and central banks won't engage in infinite-borrow-and-infinite-print policies. If governments surprise people by trying those policies, the markets could quickly adjust their expectations. You don't need a bond bubble to be afraid of a run on the currency - you just need Goodhart's Law.

40 comments:

"Well, the central bank can just print money and buy the bonds directly from the government."

Well actually, central banks can't legally do this, but they can get banks to do this for them whether they like it or not.

"A big inflation will also raise nominal interest rates, overwhelming the central bank's ability to keep them down. That will cause a government default."

Not necessarily, if it's hyperinflation then sure, BUT if it's just high inflation, this will result in souring government nominal revenues and an overheating economy, so they can both afford to and would want to raise interest rates.

I guess, but it would be easier if the central bank just restated its committed to massive and unlimited QE if at any point interest rates started getting uncomfortably high, that way the banks would be happy to buy the bonds and immediately sell them to the Fed no matter what. And it's because the banks know that they can't corner the market and beat the Fed on this, they won't let rates get out of control in the first place.

To get a hyperinflation episode you need a collapse in output, something like;France invades your principle industrial zone and expropriates - 1923, or ZPF sponsored farm invasion wiping out 50% of your agricultural sector, for Zim it main sector.

There really is a bond bubble, not speculative, as you said, but a bubble. And hyperinflaction would eventually be not more than a negative bubble on money that comes from the "air" pressure put on the previous bond bubble. The only reason that is currently avoiding such air transfer is secular stagnation. A time bomb, indeed. Can we defuse it before the new big bang?

There are some pretty strong deflationary pressures coming out of the developing world Combine that with the demographic disaster that is Europe and Japan and it is hard to see when there is going to be any burst of inflation in the developed world.

Even if we did have a burst of inflation the average remaining time to maturity on outstanding bonds is probably less than ten years. Newly issued bonds with thirty year maturities would get slaughtered but a bond with less than five years to go would not feel a big effect from inflation that slowly rises over the remaining term of the bond.

Touche! The time bomb is permanently moistened by the (by definition) permanent lack of demand (or supply) whatever the secular stagnation means. This seems to be the Japanese way of thinking about it, after two and a half decades into.I disagree, though, on your “soft landing” approach in case of a burst of inflation. When you have been issuing paper out of thin air (which is what all these financial loops are all about) expectations play a bigger role than mere financial-mathematical calculations on maturities and all that. I wish you are right, but I am afraid you are not.

Joshua - It really is going to depend on the individual investor. A diversified portfolio might well make up on the equity side what it loses on long bonds. The investors at risk of large losses are those like the Fed who have borrowed short term money to buy long term assets as part of QE. They are at risk that the interest they have to pay will be greater than the interest they collect.

"So is this a free lunch? What's the danger? The danger is that all that money-printing will eventually result in a big inflation. A big inflation will also raise nominal interest rates, overwhelming the central bank's ability to keep them down. That will cause a government default."

That is non-sense. If the money printing creates inflation and raises nominal interest rates, then the economy has returned to full employment and is out of the liquidity trap. The Central Bank should not keep interest rates at low levels. But neither does the government need to run large budget deficits to support the economy anymore. It can even switch to budget surpluses without harming the economy. That would create downward pressure on interest rates. The combination of budget surpluses with healthy growth of nominal GDP means that public debt comes down quickly. Very quickly in fact.

I don't understand. If the law is changed to allow (require?) the central bank to buy government debt directly, then the central bank can buy that debt at any rate at which it is issued. If private sector interest rates go up, the government can still roll over its debt easily by selling zero-interest debt to the central bank.

I wish you and Brad would stop playing this game of sneaking in the innovative concept of a "real default" under the established label "default". The government doesn't promise its debt purchasers a real positive return on its debt instruments. It promises them nominal returns, and if the buyer gets that nominal return the government has not defaulted. This is no different than in the private sector - a company is not "insolvent" if it legally pays off its bonds with inflation-devalued dollars. You have no claim on them if you don't make what you hoped to make from investing in the bonds.

Now it's true that if the government does this too often, people will eventually not want to buy those government bonds at all, if there are alternatives. Big deal - sayonara and good riddance then. Governments don't need to sell bonds to private investors. They can either print the money they don't want to tax or, equivalently, sell 0-interest debt to the central bank. Same thing.

Inflation is an issue as it always is. Once monetary policy is fully conjoined with fiscal policy, then fiscal policy must be conducted with an eye toward macroeconomic goals like price stability. But the question of default is not an issue.

With government interest rates moving all over the developed world into negative real territory, it's becoming clearer than ever what a racket the government bond market has been for about 300 years. The whole institution of a bonded government debt has often functioned as little more than an upward redistribution scam, allowing those with the ability to buy large portions of that debt to profit off the ordinary operations of government and the average taxpayer.

It may nevertheless be seen as a legitimate function of government to provide some very low interest safe assets as a place to park cash in bad times of deflationary pressures. We don't need government bonds for this. We can just authorize the central bank to offer interest on its own deposit accounts - which we have - and permit broad access to those accounts, either directly or indirectly.

Clearly the world is already moving in this direction. All of this is happening right in front of our eyes.

Note that there actually have been historical periods in the U.S. after the creation of the Federal Reserve when rates were held excessively low, resulting in inflation, exactly the scenario you are postulating (the WWII period was such a period, see here: http://en.wikipedia.org/wiki/1951_Accord or here http://www.richmondfed.org/publications/research/economic_quarterly/2001/winter/pdf/hetzel.pdf).

The inability to bring down inflation after a period of monetizing the deficit reflects a lack of political will to do what needs to be done (raise rates, raise taxes, lower spending). Not, a loss of control of the economy per se.

Default is a strategic option that is sometimes preferable to high inflation, taxes, or spending, because creditors are *foreign*. And, it's a lot easier to impose costs on THEM. But for a closed economy, default and inflation are the same - both involve the unexpected depreciation of principal.

Back to bond bubble: Bonds are only in a bubble to the extent that they fail to incorporate the probability of a regime change in Fed policy or politics (e.g. towards more weight on unemployment, less on inflation) inflation. If inflation got to be 15% again, it would only be because the Fed/Treasury refused to raise rates to 20%.

Were bonds in a bubble in the 1940s and early 1950s until the Fed gained independence?

I guess I should add that these days we can also look at volatility on interest rate options as a measure of uncertainty.

I am sad to report that both volatility and outright yields conform to my expectation that the Fed will have a peevish focus on sub-2% inflation for a long time. They will err on the side of raising rates too early rather than too late. I don't really need much more evidence of that than the Fed's own forecasts for inflation and unemployment. Or, Yellen's press conferences where she exhibits a severe allergic reaction to "overshooting."

No, no. Noah and others are doing good job. But I really wonder why they slip sentences like the one you quoted. It is obviously not correct and not necessary.

So the CB can always monetize the debt with zero cost if deemed necessary! Of course and obviously. But as obviously that is not always enough to save the economy the government was elected to safeguard in the first place.

Well, no, not with "zero" cost. Unemployment (tight money), high taxes, high inflation, highly variable inflation, lower spending, and debt default, all have costs associated with them. The question, is- which ones dominate at a given level of unemployment/inflation; and are policymakers incentives aligned with the general public's perceptions of costs and benefits?

I don't think you make "full MMT" full enough. As I understand it, MMT is also about a government jobs program. In fact, the crux of their argument appears to be that the government is always able to finance a public works program precisely because of the mechanisms they have to be able to create money through bond selling (and presumably taxation). Here's the rub. Inflation due to money printing occurs if that money supply is expanding at a rate greater than the expansion of economic activity (more money chasing fewer goods and all that jazz). However, if the government is printing money for the purpose of spurring economic activity by directly financing it (particularly in a recession), would you agree that this would not lead to inflation (until we perhaps take diminishing returns into account)?

The Central Bank does not need to print money in order to control bond yields. It needs to be able to threaten to print money. The price of bonds is set by arbitrage against the short rate, and the short rate can be controlled very effectively without *any* increases federal reserve liabilities outstanding. This is because the CB controls the short rate with reversible monetary operations. I.e. it adds a little more to the stock of reserves than banks need, and the overnight rate falls and keeps falling until the extra money is withdrawn. To cause the rate to go up, the CB need only withdraw a little bit more than banks need and the overnight rate will start to climb and will keep climbing until the CB adds it back. So for a given level of reserves desired by the bank, there are an arbitrary number of overnight interest rates. From that, the other rates follow. Private sector opinions about how much yield they want mean nothing, it's all arbitrage.

Moreover, just as it is possible to set the yield to be whatever you want without increase the amount of reserves, it is just as impossible to save money by monetizing debt, because in order to keep the overnight rate from dropping to zero as soon as you increase reserves by a little bit, you need to pay interest on reserves, at which point there is no reason to prefer money financing to debt financing, as they are identical.

Therefore the dynamic you describe is impossible in an economy with modern financial arrangements. Its not possible for the CB to money finance anything at all, regardless of how many reserves it creates. It will just end up paying interest on those reserves.

Think of it this way: there's some inflation rate that maximizes seignorage. Suppose it is 10%. Then the central bank can "finance" an amount of spending equal to 10% of the monetary base, i.e. the base increases by 10% per year (without any real GDP growth). Attempts to "money finance" more than that will fail.

Central banks are irrelevant. Printing money is treasuries business and will always be treasuries business. It was treasuries business when LBJ printed money to pay for guns and butter during the 60's despite the Fed's objections.

Wait a minute. Why would inflation cause a government to default on its existing stock of debt? Based on the story you are trying to tell, the interest rate on the existing stock of debt is 0. Just because the interest rate on the new debt is a large positive number doesn't mean that the government suddenly has to start paying that large interest rate on its existing stock of debt. Let me lay it out for you:

Suppose the economy is depressed and inflation expectations for the next 10 years is -2% and the real interest rate is 2%. At this point (t0), the government borrows for $100 for 10 years at a nominal YTM of 0%. So the stated coupon on the t0 series bond is 0. Let us assume that this process continues in periods t1, t2, t3, and t4 and coupon is 0 in each case because expectations are as I outlined. Now suddenly at time t4+dt, expectations switch and suddenly market expects inflation of 10% and real rate is still 2%. Then, surely the bond that will be issued at t5 will carry a coupon of 12% but the government does not have to pay 12%. Also, because expectations have switched, the market price of the bonds issued at t0 to t4 will fall dramatically. As an example, the t0 series bond which now has 5 years remaining to maturity will probably be selling for $56 ($100 discounted at 12% for 5 years), the t1 bond will sell for ~$50 (6 yrs to maturity and 12% discount rate). So technically, the government could buy back those two bonds with proceeds from the t5 bond. Where is the question of default?

Also, if expectations for inflation have suddenly shifted from -2% to 10%, then something must be going on in the economy which will likely drive higher tax revenues. Finally, if the currency depreciates dramatically, then I would argue that exports would increase which is of course positive for GDP.

Your arguments are valid only if the shift from -2% inflation to 10% inflation is permanent AND the channels through which the shift is realized produces no increase in GDP/taxes etc.

Fair enough. The broader point I was trying to make, however, is that the assumptions are quite draconian. Full disclosure, I am not an economist but my recollection of the quantity theory of money (P=MV/T) suggest that inflation can occur either because M has increased faster than T or if V explodes with P&T remaining constant. I think you need to spell out the story / mechanism for the bond bubble more clearly. My guess is that your bond bubble story would work only if V first collapses and then the bubble bursts if V explodes. If inflation is driven by M going up faster than T, then central banks can exercise control. What central banks cannot exercise control on is the behavior of V. Witness the lack of inflation despite an explosion in M (offset completely and then some by a collapse in V). I think the mechanism needs to be explored and thought through and who knows what a formal model says.

... and just keep the consolidated debt structure at short duration - short bills, hyper QE, direct CB buying ... whatever ... and with bonds the CB earns the curve spread and just sends it back to treasury ... no nominal default

You wrote:"The danger is that all that money-printing will eventually result in a big inflation. A big inflation will also raise nominal interest rates, overwhelming the central bank's ability to keep them down. That will cause a government default."

During WW I the United States government offered a series of four “Victory Liberty Loans” (i.e. War Bonds). After the war a fifth bond, for post-war reconstruction, was issued. Sales of the first four had not gone too well so with each new offering the government had to “sweeten the deal”. The fifth bond was offered to US citizens at 4.75% interest and was to be redeemed in gold.

The cost of the war was tremendous and taxes were raised accordingly, the top bracket increased from 6% to 77%. The total cost of the war was about 30 Billion United States Dollars (BUSD). The entire Federal Budget in 1912 was just under 1 BUSD. While the first four bonds were retired in good order, fifth “post-war” war bond which was maturing in the 1930′s when the country was in the worst throws of the depression. Part of the reason was that Secretary of the Treasury Mellon fought for and got very significant tax cuts, the top bracket dropped to 25% by 1925.

When the Great Depression hit, it was extremely difficult for the government to pay off the fifth round of bonds. Rather than attempt to pay the last of these bonds off, President Roosevelt got Congress to pass House Joint Resolution (HJR 192) in April of 1933. The US government then attempted to pay this last bond at a fraction of the face value and not in gold but paper, i.e. USDs.

However, this was challenged in the court and in Perry v. United States the SCOTUS overturned HJR 192.

SCOTUS ruled: “The Joint Resolution of June 5, 1933, insofar as it undertakes to nullify such gold clauses in obligations of the United States and provides that such obligations shall be discharged by payment, dollar for dollar, in any coin or currency which at the time of payment is legal tender for public and private debts, is unconstitutional…. By virtue of the power to borrow money ‘on the credit of the United States,’ Congress is authorized to pledge that credit as assurance of payment as stipulated — as the highest assurance the Government can give — its plighted faith. To say that Congress may withdraw or ignore that pledge is to assume that the Constitution contemplates a vain promise, a pledge having no other sanction than the pleasure and convenience of the pledgor. When the United States, with constitutional authority, makes contracts, it has rights and incurs responsibilities similar to those of individuals who are parties to such instruments. The right to make binding obligations is a power of sovereignty. The sovereignty of the United States resides in the people, and Congress cannot invoke the sovereignty of the people to override their will as declared in the Constitution. The power given Congress to borrow money on the credit of the United States is unqualified and vital to the Government, and the binding quality of the promise of the United States is of the essence of the credit pledged. (P. 293 – 294)."

While SCOTUS ruled that the United States government may not legally default on its bonds, it provided no remedy to the plaintiff. The United States government did indeed default on the fifth series of the war bonds. Interestingly, inflation had nothing to with this default. The US economy was plagued by deflation at the time.

I think you need to provide an explanation as to how all of that "money printing" leads to inflation, especially in the US.

First of all, the full MMT option isn't money printing. It is giving credit to the government, which then spends the money and puts it 'into circulation' in a bunch of numbers in computers. The risk of inflation comes from too much consumption. The major risk for runaway inflation is too much consumption for too long.

You can cut consumption quite quickly by cutting government consumption. All of this revolves around the artificial idea of the aggregate 'price level'. It revolved around the idea that price level is meaningful to consumers. The inflation rate has very little to do with the amount of money in circulation. It only has to do with expectations and the percieved wealth of consumers.

I think the problem here is that you're talking about a select few people who believe in the bond bubble theory and ignore their numbers. They are few. If they were many, if they were largely the consumers in the economy, this would be a problem. It this isn't something that has definite boundaries.

So the question people ask is why Argentina or other small nations had inflation reportedly caused by 'money printing'. It wasn't caused by that. It was caused by subsidies that inflated prices in certain key markets. The average consumer cannot discriminate between their own consumption markets, and they tend to assume inflation crosses over markets (there's plenty of macro propaganda to confirm this). They get worried.

The point is that without looking at the factors that enter into the minds of the consumers, inflation is meaningless. As a function of money in the system it is meaningless. The more important factor, when governments print money, is the effect they have on the consumption markets. They take that money and buy stuff, and if the markets cannot respond fast enough by increasing supply, and if the average consumer perceives this as 'inflation' that economists report all the time, then we have inflation.

Perhaps the reason none of this matters in this liquidity trap is because the low-cost lending the Fed is providing cannot be consumed indiscriminately. The rates most consumers have on their spending today are in the double digits through credit cards. The time of low-rate mortgage-based consumption is over.

So no matter how low the Fed rates are, consumers are still being gouged by credit companies. Only the government can borrow this low. So the government should be spending, spending, spending…

There's no question that bond bubbles do exist, but most of the contemporary American talk of a bond bubble is I think a misuse of the term by people who really just mean they think bonds are overpriced ie interest rates are too low.

"Bubble" isn't a precisely defined term anywhere anyway, but usually it refers to popular enthusiasm for some financial asset driving an unsustainable divergence between the asset's short-term financial performance and its real performance. A clear example of a sovereign bond bubble in my mind would be Russia 1995-1997. Note that yields were quite high. They were paid from growing issuance as long as fund mangers kept piling in to what was essentially a Ponzi. As I recall Larry Summers strongly endorsed them and a lot of his friends went in heavy.

If one were trying to make an argument that the US was in a bond bubble, I guess you would want to time travel back to 2011 or earlier and argue that QE in combination with private demand for Treasurys was enabling out-of-control deficits that might eventually go bust. That was one of the risks S&P saw. But that argument was overstretched then, and it was made passe by the 2011 budget compromise.

I would describe a bubble as a badly mispriced asset class that is significant enough to cause a major economic adjustment when the price of that asset class collapses. It is clear that the Fed has very little impact on M2 and velocity, even with its nearly infinite QE policy. However, if government bonds are badly mispriced then the consequences will be severe for the owners of those bonds when they are revalued. Currently the Vanguard Extended Duration Treasury ETF - which tracks the performance of 20-30 year U.S. Treasury STRIPS has a duration of 25 years. This means that those owners would incur a 25% loss if interest rates on long-term Treasuries increase by 1%. Considering that the 30-year Treasury is yielding about 2.5%, it is not inconceivable that they could incur losses on the order of 50% if the 30-year Treasury moved back up to 4.5%, an interest rate consistent with the pre-"Great Recession" era. Think of all the pension funds, 401K plans and IRAs that would be affected. It could result in the next downturn. The only upside would be a thorough discrediting of the QE school of economics.

Hi Noah,Someone in the comments section may have addressed this earlier.

Without knowing Goodhart's Law, or MMT really, I feel that appealing to the extreme (reserve currency sovereign issuing 'infinite' face value of bonds) while it might offer some insights, does not really help in forming expectations as they relate to constructing a meaningful duration bond portfolio. I think what would be truly helpful is, if someone like you could actually provide a number for Global Excess Savings, that Ben Bernanke speaks about routinely. This saving is trying to find a capital preserving 'home', at least on a nominal basis.

The nominal 10yr yield on German Bunds is practically zero, and the US 10-yr at 1.88% is by comparison a high yield issue! For the U.S with a $17.7tr gdp, a $18 tr outstanding debt is really not much at all, when the duration adjusted servicing is roughly 1.1% p.a.

The current maturity profile can easily be rolled through CB buying (with the CB engaging in seignorage etc.).

So again, what are the rates of the Excess savings formation globally? What are the expected growth rates? Those two critical questions are far more important than exploring the possibility of high inflation landing on us suddenly.